Performance Evaluation and Compensation Research: An Agency Perspective

INTRODUCTION How managers and executives are evaluated and rewarded has become an increasingly contentious issue in recent years. The benefits and pitfalls of firms’ compensation practices are routinely featured in the business press and have attracted considerable attention from governments, unions, as well as the investment community.1 In some cases, this increased attention can be attributed to the apparent excessive levels of remuneration paid to U.S. executives.2 More generally, it reflects a heightened awareness that performance evaluation and reward systems are critical because they affect employees’ incentives to increase shareholder value. The link between shareholder value and managerial incentives has also attracted considerable attention in the academic community. Questions regarding the structure of executive compensation contracts and the incentives that these contracts provide have been of interest to researchers for several decades (e.g., Berle and Means 1932; Jensen and Meckling 1976). More recently, financial economists have explored the link between compensation practices and corporate investment and financing decisions (e.g., Smith and Watts 1992). Accountants have studied managerial incentives to manipulate accounting earnings in response to accounting-based compensation schemes (e.g., Healy 1985). Sociologists and psychologists have examined a variety of behavioral issues associated with organizational pay practices such as those concerning pay equity and social comparisons (e.g., O’Reilly et al. 1988). While different paradigms and methods have been used to study how managers are evaluated and rewarded, the overriding